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Foreign 'Blocker' Corporations with No FATCA Documentation: What Happens Now?

Trust Bloomberg Tax's Premier International Tax offering for the news and guidance to navigate the complex tax treaty networks and business regulations.

By Thomas S.
Bissell, CPA

Celebration, FL

It is extremely common for foreign
individuals to invest in U.S.stocks, bonds, and other U.S.-situs assets
(such as U.S. realestate) through a wholly owned, foreign corporation in
order toavoid potential U.S. federal estate tax (FET) upon death. This structure is typically used by non-U.S. citizens who aredomiciled
outside the United States - and thus not "resident" inthe United States
under §2001(a) for FET purposes - and who alsoare not protected from FET
under a U.S. estate tax treaty.1 Such a foreigncorporation, often called a "blocker,"
is usually incorporated in ano-tax jurisdiction that has no income tax
treaty with the UnitedStates. This commentary discusses the FATCA rules
that apply wherea "blocker" owns only stock in U.S. corporations and
debtobligations of U.S. persons. The stock or the debt obligationsowned by the blocker might or might not be publicly traded.

For U.S.
federal income tax (FIT) purposes, a blocker in anon-treaty country is
typically subject to 30% tax on U.S.-sourcedividends under §881(a)(1).
Because most debt obligations (exceptobligations of certain related U.S.
corporations) qualify for the"portfolio interest" exemption in §881(c),
however, U.S.-sourceinterest is usually exempt from FIT. In addition,
gains from thesale or exchange of stock in U.S. corporations (other than
U.S.real property holding corporations) and debt obligations of U.S.persons are typically exempt from FIT because the gains are usuallynot
effectively connected income under §882. In order to avoidbackup
withholding under §3406 on interest and on the grossproceeds from the sale
of U.S. stocks and bonds, however,historically the blocker has been
required to furnish theapplicable U.S. withholding agent with IRS Form
W-8BEN in order tocertify its foreign status. In accordance with Form
W-8BEN,the U.S. withholding agent then withholds 30% on U.S.-sourcedividends under §1442 (in Chapter 3 of the Code), but it does notwithhold on portfolio interest or on the gross proceeds from thesale of
U.S. stocks and debt obligations.2

The FATCA rules in §1471-§1474 (in
Chapter 4 of the Code)require that a set of withholding rules which are
roughly parallelto §1442 be applied where a "withholdable payment" (as
speciallydefined) is paid to any foreign "entity" that has not provided
theU.S. withholding agent with documentation that satisfies the FATCArequirements. Significantly, the term "withholdable payment"includes
U.S.-source interest even if it otherwise qualifies forthe portfolio
interest exemption in §881(c) - unless the debtobligation is a pre-7/1/14
"grandfathered obligation"3 - and starting onJanuary 1, 2017, the term also
includes gross proceeds from thesale or exchange of U.S. stocks and debt
obligations. In a mannersimilar to the backup withholding rules of §3406,
FATCA withholdingis imposed at the rate of 30% on gross income and, after
December31, 2016, on gross proceeds.4 Although in many casesthe foreign
entity may claim a refund of the FATCA-withheld tax ifthe amount withheld
exceeds the amount that would have beenwithheld under §1442, as a general
rule if the entity is a"nonparticipating foreign financial institution"
(as defined inReg. §1.1471-1(b)(82)), it may not be able to claim a refund
unlessit is resident in a tax treaty country.

The first phase of
the FATCA rules finally took effect on July1, 2014. Except for gross
proceeds from the sale of designatedU.S.-situs assets, 30% withholding
started on July 1, 2014, under§§1471 and §1472 with respect to
"withholdable payments" for whichthe foreign entity realizing the income
had not provided the U.S.withholding agent with documentation that
complied with the FATCArules.

The Form W-8BEN that a blocker
corporation has historicallycompleted required only that the entity
certify that it was a"foreign person" that was classified as a
"corporation." Because ofthe extreme complexity of the FATCA rules,
however, effective July1, 2014, a foreign corporation that wishes to
comply with FATCAmust determine its status either as a "foreign
financialinstitution" (FFI) or as a "non-financial foreign entity"
(NFFE)under §1471 and §1472, and also which one of the many FFI or NFFEcategories it falls within. Depending on how the foreigncorporation is
classified, in many cases it must file additionaldocumentation directly
with the IRS and/or provide additionalinformation about itself and about
certain other persons(especially U.S. persons) who are related to it in
some manner.Once a foreign corporation has completed a proper Form
W-8BEN-E,that form will be effective for purposes of both §1442 (Chapter
3)and FATCA (Chapter 4), and if the corporation has previously fileda pre-FATCA Form W-8BEN with the particular withholding agent, thenew
Form W-8BEN-E will replace it.5

It is clear under the law that where a foreign
blocker has neverprovided proof of its foreign status to a withholding
agent priorto July 1, 2014, but wishes to do so on or after that date, the
newForm W-8BEN-E must be used for §1442 purposes as well as for FATCApurposes.6
In addition, if theblocker owns its U.S. securities through an account
that ismaintained with an FFI, in most cases the FFI will have beenattempting to obtain the FATCA-required documentation from theblocker
prior to July 1, 2014. But what happens if the blocker ownsits U.S.
securities directly in its own name or through an accountwith a U.S.
financial institution, and has not provided therelevant U.S. withholding
agents with Form W-8BEN-E in order toinform them of its status for FATCA
purposes? The instructions tothe pre-FATCA Form W-8BEN indicated that it
was valid for threeyears, but that in many cases it was valid indefinitely
if theforeign person provided a TIN. Did pre-existing Forms W-8BEN
issuedby foreign corporations (and other foreign "entities") becomeinvalid on July 1, 2014, and, if so, did those foreign corporationsbecome "undocumented" on July 1, 2014, and thus subject to backupwithholding under §3406 not only on U.S.-source dividends andinterest
but also on gross proceeds from the sale or exchange ofU.S. stocks and
bonds?

The final FATCA regulations appear to deal with this issueindirectly, although they do not specifically state that apre-existing
Form W-8BEN that has not expired will continue to bevalid for Chapter 3
(§1442) purposes. Reg. §1.1471-3(d)(1) providesthat a pre-existing Form
W-8BEN that has not expired may be reliedupon for FATCA purposes if the
withholding agent has certainadditional documentation that is reliable
concerning the foreignpayee's probable FATCA status. The regulations do
not say whathappens for §1442 purposes if the withholding agent has nosupplemental information at all from the foreign payee, but thestrong
implication is that the existing Form W-8BEN is stilleffective for §1442
purposes, even though in this situation it isclearly not effective for
FATCA purposes. In addition, Reg.§1.1471-3(f)(4) establishes a presumption
that if a withholdingagent cannot determine on the basis of a "valid
withholdingcertificate" (or other "valid documentary evidence") what
status aforeign "entity" has for FATCA purposes, the entity is presumed
tobe a nonparticipating FFI - and not a completely undocumentedentity that would thus be subject to backup withholding under§3406.
Because the FATCA rules are so extraordinarily complex,however,
undoubtedly there are many U.S. withholding agents whowill be skittish
about this issue and who may wish to apply thebackup withholding rules of
§3406 if they do not have a new FormW-8BEN-E from those foreign payees who
indicated on their originalForm W-8BEN that they were a "corporation."
Unfortunately, the 2014edition of IRS Publication 515, Withholding of
Tax onNonresident Aliens and Foreign Entities, has not yet beenpublished as of this writing, and the 2013 edition contains only abrief
mention of FATCA and a link to the FATCA portion of the IRSwebsite. Not
surprisingly, however, the FATCA portion of the IRSwebsite contains
numerous IRS documents, and in addition thosedocuments do not appear to
focus on this specific issue.

If it is assumed, however, that a
withholding agent is properlyadvised and continues to respect a foreign
blocker's unexpired FormW-8BEN for §1442 purposes but not for FATCA
purposes, what is thepractical effect for a blocker whose only U.S.
investments are instocks and bonds?

U.S.-source
dividends - 30% withholding will beimposed under FATCA, the same as
the 30% rate that is imposed under§1442 (because the blocker is resident
in a country without a U.S.income tax treaty). Because duplicate
withholding cannot be imposedunder both §1442 and under FATCA, there will
be no additional U.S.tax on the blocker as the result of its undocumented
FATCAstatus.

U.S.-source interest - Although FATCA
can beimposed on U.S.-source "portfolio interest" that is exempt from§1442 withholding, if the debt obligation qualifies as a pre-7/1/14"grandfathered obligation," no FATCA withholding will be imposed.However, if the blocker purchases newly issued debt obligations onor
after July 1, 2014, or if a pre-7/1/14 debt obligation is"materially
modified" on or after July 1, 2014, 30% FATCAwithholding will be imposed
on interest that is paid on that debt,even if it is portfolio interest for
§881(c) purposes. If FATCAwithholding is imposed on portfolio interest,
the blocker will thenwant to consider filing a refund claim with the IRS,
provided that,before doing so, it furnishes all its missing FATCA
documentationto the IRS (and to any withholding agents who will continue
to bemaking "withholdable payments" to the blocker). Based on thedetailed refund procedures set forth in Reg. §1.1474-5, the onlysituation in which the blocker would be prevented from claiming arefund
would be if it were a "nonparticipating FFI" that is notresident in a
country having an income tax treaty with the UnitedStates.7

Gross proceeds from the sale or
exchange of U.S. stocks andbonds - Because FATCA withholding on gross
proceeds from thesale or exchange of U.S. stocks and bonds will not begin
untilJanuary 1, 2017, the blocker's existing Form W-8BEN can be reliedupon to avoid both FATCA withholding and backup withholding under§3406.
Note that the exemption from FATCA withholding will applyuntil January 1,
2017, even if the debt obligation is newly issuedafter June 30, 2014 (or
is pre-7/1/14 debt that is "materiallymodified" after June 30, 2014), and
thus is not a "grandfatheredobligation," whether or not it also happens to
be "portfoliodebt."

In light of the massive publicity that has
accompanied theintroduction of FATCA, one might ask how there could be any
foreignblockers that have not yet replaced their pre-FATCA Form W-8BENwith a new Form W-8BEN-E. As suggested by the examples immediatelyabove,
many foreign blockers may be fully informed about FATCA butmay simply have
delayed updating their documentation - especiallysince the examples just
given suggest that for many blockers theremay be little or no practical
effect until at least January 1, 2017(or until their existing Form W-8BEN
expires, if sooner). But manyblockers may simply not be aware of the new
rules, includingblockers that are managed by one or more foreign family
membersrather than by an institutional trust company. The U.S. payor
mayalso be unaware of the FATCA rules, especially if the payor is aprivately held U.S. company and/or a U.S. borrower that does nothave a
tax advisor that is familiar with internationaltaxation.

Although a
discussion of when a blocker might be classified asan FFI or as an NFFE
(and into which category of FFI or NFFE theblocker fits) is beyond the
scope of this commentary, it should benoted that the FATCA regulations
appear to expand the scope of thestatute for many blockers that are owned
solely by one or moremembers of a foreign family. Thus, while it might be
assumed fromthe language of §1471 and §1472 that a closely held blocker
that isowned and managed solely for the benefit of a single foreign
familywould be classified as a passive NFFE, if the blocker is
"managed"by an entity that itself is an FFI - such as an institutional
trustcompany - the regulations classify the blocker itself as also
beingan FFI. A blocker will also be classified in most cases as an FFIif it is owned by a foreign trust that has an FFI as its trustee.8 As discussed above,for the time being
the FFI/NFFE distinction may not matter exceptfor interest paid on
"portfolio debt" that is newly issued (ormaterially modified) on or after
July 1, 2014. However, thedistinction will clearly become much more
important on and afterJanuary 1, 2017, when gross withholding starts under
FATCA, becausea nonparticipating FFI with no tax treaty protection will
not beable to recover the 30% withholding tax on gross proceeds thatapplies then.

In the meantime, however, it would certainly be helpful
if theIRS could expedite the publication of its 2014 edition ofPublication 515, and in addition make absolutely clear (perhaps ina
special IRS Notice) that a pre-7/1/14 Form W-8BEN will continueto be
effective according to its terms for §1442 purposes, eventhough it clearly
will not be effective for FATCA purposes.

This commentary also will
appear in the August 2014 issue ofthe Tax Management International
Journal. Formore information, in the Tax Management Portfolios, see
Nauheim,Cousin, Ewell, Limerick, Lakritz, and Lee, 6565 T.M., FATCA
-Information Reporting and Withholding Under Chapter 4, and in
Tax Practice Series, see ¶7170, U.S. InternationalWithholding and
Reporting Requirements and FATCA.

1 For a detailed discussion of these
rules,see Bissell, 903 T.M. (Bloomberg BNA Tax &Accounting), Tax Planning for Portfolio Investment into theUnited
States by Foreign Individuals. If the owner of theforeign corporation
becomes a "resident alien" for U.S. federalincome tax purposes under
§7701(b), he or she may be subject toU.S. federal income tax on the
corporation's income under theSubpart F and/or the passive foreign
investment company (PFIC)rules of the Code, but if the owner remains
domiciled outside theUnited States, the underlying U.S.-situs assets will
still beprotected upon the owner's death from FET. See 903T.M., VIII.

2 In addition, U.S.-source interest that
does notqualify for the portfolio interest exemption in §881(c) is alsosubject to 30% withholding under §1442.

3 The principal category of
"grandfatheredobligations" are those obligations that are outstanding on
July 1,2014, and have not been subject to a "material modification" on
orafter that date. See Reg. §1.1471-2(b)(2)(i)(A) andReg.
§1.1471-2(b)(2)(iv). Although there are two other categoriesthat are
included in the definition of "grandfathered obligations"- obligations
that give rise to a dividend equivalent under §871(m)and certain security
agreements relating to an otherwisegrandfathered obligation - this
commentary discusses onlyobligations that are outstanding on July 1,
2014.

4 It should be noted, however, that the
backupwithholding tax rate for 2014 is 28%, not 30%.

5 It should be stressed that Form W-8BEN continuesto be required from foreign individuals, who are notaffected by
FATCA to the extent that they own U.S.-situs assetseither directly in
their individual name, or through an accountwith a U.S. financial
institution.

6See the recently releasedInstructions for Form W-8BEN-E (June 2014). This situation wouldusually
arise either where the foreign blocker is newly created onor after July 1,
2014, or where it was in existence prior to July1, 2014, but had never
made an investment in the United States forwhich the completion of Form
W-8BEN was necessary.

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